We do not believe the bear market is over. In our view, the repercussions from potential energy and food shortages this summer, relentless inflation, and rising interest rates will weigh heavily on the economy, profit margins, and earnings in 2022. Still, the peak to trough declines made in the broad indices recently, have been significant. The Dow Jones Industrial Average, the S&P Composite, the Nasdaq Composite, and the Russell 2000 have had selloffs of 15.0%, 18.7%, 29.8%, and 27.8%, respectively. Now that earnings season is nearly over, we think the opportunity for a rebound in equities is materializing. The only risk this week is the release of May’s CPI report on June 10 which most economists expect will display a deceleration in inflation. This is possible but with crude oil prices up 62% YOY we doubt that inflation can moderate much in the near term. While it is feasible that headline CPI could decelerate a bit from April’s 8.2% YOY pace, we expect inflation to remain stickier and more persist than most expect. This will be a major problem for the Federal Reserve and the economy.
Nevertheless, the technical charts of companies like Walmart, Inc. (WMT – $123.37), Costco (COST – $471.78) and Target Corp. (TGT – $155.98) suggest that a lot of bad news regarding profit margin pressures and earnings weakness is being priced into segments of the marketplace. See page 3. This builds a foundation for a rebound rally.
But in general, we still believe an overweight position in inflation-resistant stocks is the best policy for investors. In the longer term, the risk of a recession increases, and we doubt that this has been fully discounted by equities. Nevertheless, our favored sectors also are recession resistant and thereby serve both purposes. In short, our suggested overweight sectors remain energy, staples, industrials (emphasizing defense stocks), and utilities. See page 13. We consider these to be core portfolio holdings.
Still, trading opportunities will appear in other sectors and individual stocks from time to time. For example, the retail sector is currently deeply oversold and could rebound substantially from recent lows. But we would view these situations as short-term trading opportunities.
Risk of Recession
Most economists are now discussing the possibility of a recession in late 2023, but we think the risk could be sooner though many experts disagree. Treasury Secretary Janet Yellen testified before the Senate Finance Committee this week and she apologized for being wrong about her stance on inflation which she described as being “transitory” last year. And we find ourselves disagreeing with her once again. In her testimony, she described the economy as being in “good shape” and households as being “resilient due to their high savings rate.” Unfortunately, the Treasury Secretary does not seem to realize that the personal savings rate fell to 4.4% in April, its lowest level since September of 2008! Keep in mind that the economy was in a recession from December 2007 to June 2009. In sum, it is difficult to have confidence in the economy if the administration does not have a grip on inflation or the state of the consumer.
Our nature is to be bullish, however, we see a number of red flags on the horizon that are being ignored and this concerns us. For example, the ISM indices for the month of May were disappointing. The ISM manufacturing index inched up to 56.1 in May, nonetheless, May was the second lowest reading in 20 months. The ISM nonmanufacturing index fell to 55.9 and it was the worst reading in 15 months. However, both main indices remain above 50 which is a sign of a good, albeit not robust, economy. More worrisome were the employment indices. The employment index fell to 49.6 in the manufacturing survey and down to 50.2 in nonmanufacturing. A number below 50 is a sign of contraction in activity. See page 4.
Two key areas of the US economy are housing and autos, both of which are on our radar since they will be negatively impacted by rising interest rates as the Federal Reserve continues its tightening policy this year. Housing has already shown signs of sluggishness in recent months, particularly in homebuilder sentiment and homebuyer traffic data. Last week’s data for May’s auto sales was also a disappointment. Total light vehicle unit sales were 12.7 million, on a seasonally adjusted annualized rate (SAAR), which was 25% below the pace a year earlier and 12.6% below April’s level. A lack of inventory contributed to this decline, but that is not an easy problem to solve. According to a 2021 report from the Boston Consulting Group and the Semiconductor Industry Association, 92% of the world’s most advanced semiconductors are manufactured in Taiwan, with the other 8% being manufactured in South Korea. In short, the semiconductor shortage is not a post-pandemic problem but is in reality a long-term problem in search of a solution. It is another sign that inflation may be difficult for the Fed to control.
But in terms of auto sales, keep in mind that they are a large component of retail sales. And as we discussed last week, retail sales have been an excellent lead indicator of the US economy and a particularly good predictor of a recession. In fact, over the last 50 years, a decline in year-over-year real retail sales, when measured on a quarterly basis, has accurately predicted every recession. There have already been two consecutive months of negative real retail sales; but if this trend continues, it will increase the prospect of a recession later this year. See page 5.
Inflation, the Fed, and recession are incontrovertibly linked in 2022. In April, headline CPI was 8.2% YOY and even after two fed rate hikes, short-term interest rates remain at an historically negative (and easy) level of negative 7.2%. The Fed has indicated that it wants to get to a neutral fed funds rate, but even if we assume the year-end inflation moderates to 5%, the fed funds rate would have to increase 400 basis points to simply match inflation. If a 5% fed funds rate materializes, we expect the housing market would slow quickly and hurt economic activity meaningfully. It would also increase the odds of an inverted yield curve — another sign of a pending recession. See page 6. In short, we see danger from both inflation and recession this year and the Fed is caught in the middle.
Technical Rebound The odds of a rebound in prices are high with most of the indices trading well below important moving averages. It would be normal for the indices to test their 100-day moving averages at this juncture. For reference, these levels are 33,905 in the Dow Jones Industrial Average, 4323 in the S&P Composite, 13,230 in the Nasdaq Composite and 1971 in the Russell 2000 index. See page 9.
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